Exchange Traded Funds

An exchange traded fund, or EFT, might best be described as a hybrid between a share of common stock and a mutual fund.  In fact, because of the way EFTs are structured, they present some interesting options to both the novice and seasoned investor.

Defining an Exchange Traded Fund

Generally, EFTs are portfolios of securities (just like a mutual fund) that are actively traded on a stock exchange (just like a share of common stock).  When first introduced, exchange traded funds attempted to duplicate a commonly-known, and well-respected, market index such as the NASDAQ 200 or the S&P 500.

Today, EFTs provide investors with a much wider selection of investment options including currency, gold or silver, commodities, as well as natural resources such as oil, natural gas, and other energy products.  Even with all of this diversity, exchange traded funds share some common characteristics including:

• They are listed on a stock exchange, and traded continuously.
• They can trade at a discount, or premium, to the total value of all assets held within the EFT.
• They are typically based on some well-known stock index, or are well-defined with respect to the allowable investments.  This keeps turnover and other fund management costs low.

Benefits of Exchange Traded Funds

Since ETFs are traded just like common stock, investors enjoy the flexibility of exchanging shares on a stock market.  For example, you can invest in shares on margin, short sell shares, or take a long-term position.  Investors would purchase and sell these funds just like common stock, through their broker, and shares in EFTs are traded throughout the exchange day.

Limiting Market Risk with EFTs

Exchange traded funds also provide the investor with the ability to purchase a portfolio of stocks, thereby eliminating individual stock risk.  They are also designed to be efficient because, just like a mutual fund index, they are not actively managed.  The portfolio is only adjusted, or balanced, to contain the right mix of the index it is mirroring.

These funds do, in fact, enjoy a robust trading market.  The NASDAQ 100 tracks some of the fastest growing technology companies listed on that exchange.  There is a NASDAQ Index tracking stock, QQQ, which is one of the most actively traded funds of this kind in the world.  The latest statistics indicate that over 76 million shares of this fund are traded daily.

Recapping, it seems that exchange traded funds offer the benefits of a mutual fund index fund, but add the flexibility of stock trades.  This combination is quite attractive to investors.  Unfortunately, there are some big disadvantages of ETFs that are worth mentioning too.

Disadvantages of Exchange Traded Funds

Just like common stocks, you will need to pay brokerage commissions when shares are traded.  Unlike most mutual funds, you might also pay embedded fees that can eat into your return on investment.

For example, many funds sell at a bid - ask spread.  Meaning you might purchase shares at $10.125, but selling is occurring at $10.000.  These funds don't always sell at the Net Asset Value (NAV) of the underlying portfolio, so trades could take place at prices above or below the value of the assets.  This is referred to as selling at a premium or discount.

Because of these commissions and underlying fees, a mutual fund index generally supplies superior returns to the investor.  If you are making small, monthly purchases of an EFT, the commissions will significantly impact the investor's total return.

Federal Tax and EFTs

According to SEC regulations, there is a small tax advantage ETFs have over mutual funds.  However, if you're purchasing shares for a non-taxable account, such as a 401(k) account or an IRA, then this advantage does not apply.

For example, mutual funds in the United States are required to realize a capital gain that is not necessarily balanced by a loss.  This can happen as new shares of an open-ended mutual fund are created or destroyed through purchases and redemptions.  The fund managers are thereby forced to purchase and redeem shares of stocks that make up the fund on the open market.

The SEC requires all mutual funds to distribute capital gains to the fund's shareholders each quarter, which can have some undesirable capital gains tax implications to your federal income tax return.  Since EFTs are not redeemed by shareholders but exchanged on the open market, the only time capital gains taxes come into play is when that individual shareholder closes out their position.

Top EFTs on the Market Today

We're going to finish this publication on exchange traded funds by providing a list of some of the more common / popular funds on the market today, as determined by daily trading volumes.  These funds have been broken down into two categories:

• U.S. Index-Based EFTs
• Commodity-Based EFTs

The two tables below contain the fund names, stock ticker symbols, as well as the daily trading volume as of April 2011:

U.S. Index-Based EFTs

Commodity-Based EFTs H3

 About the Author - Exchange Traded Funds

Bill Sharlow is the Editor of Money-Zine.com.  Copyright © 2004 - 2011 Money-Zine.com